What are Penny Stocks and How Do They Work?

Penny stocks may sound enticing but do you know what penny stock are and how they work? Find out if these riskier investments are right for your portfolio.

So you’ve recently overheard someone talking about trading penny stocks and the massive gains they made on their investment and now you want a piece of the action. While these stocks may sound appealing, they are certainly not for everyone. Before jumping into buying for your first penny stock, it is important to understand what penny stocks are and exactly how do penny stocks work.

What’s a Penny Stock?

Penny stock trading is a riskier, more speculative type of investment where shares of these companies are trading at less than $5 per share. These stocks often trade on pink sheets or over-the-counter bulletin board (OTCBB) and are regulated by the Securities and Exchange Commission with specific rules to follow.

Penny stocks not only have multiple terms, they also have multiple accepted definitions. Although sometimes referred to as penny shares or micro-cap stocks, the latter is often associated with a company’s smaller market capitalization (between $50 and $300 million) while penny stocks are categorized by their per share price. While a common acceptance of a penny stock are those trading at less than $1 per share, the Securities Exchange Commission defines penny stocks as those trading under $5 per share. Penny stocks are mostly found outside of the major market exchanges, however, companies on major exchanges with lower stock prices are also sometimes referred to as penny stocks.

How Penny Stocks Work

Pennystocks essentially trade like any other stock while carrying added risk. With lower volume, penny stocks trade hands less frequently making these investments less liquid. Penny stocks are also susceptible to higher price swings, all of these factors make penny stocks dangerous investments.

Due to their lower per share price and smaller market capitalization, penny stocks carry increased risk and are made up of highly speculative, unproven companies. With less coverage from large institutional investors, these stocks offer less information making it tougher to make sound trading decisions. Because they are not required to file with the SEC, the information that is available is often less credible. Penny stocks are also regarded as illiquid investments with less shares of these companies trading hands every day. Less liquidity increases the chances of not finding a buyer and being forced to sell at unwanted prices. This makes day trading difficult. Additionally, these companies are often the subjects of price manipulators who will purchase large quantities of a stock, then artificially inflate the share price through false and misleading positive statements (known as pump and dump).

Are Penny Stocks Worth it?

Investing in penny stocks can be worth it if the investor fully understands the risk that these securities carry. The investor should only use money that they are prepared to lose and make sure that this investment fits into the strategy of a diversified portfolio. Penny stocks must be navigated with extra due diligence and caution.

Investors should set realistic expectations when purchasing penny stocks recognizing that the odds are usually against them. The buyer must also be prepared for the potential large losses that can occur from these investments. Before buying these types of stocks, ensure that you have amassed a core group of solid companies in your portfolio and make sure that these speculative stocks are only a small fraction of your investments. Before purchasing penny stocks, get used to how they trade with Wall Street Survivor’s practice trading account and ensure that penny stocks are the right investment for you.

8 Things you should know about Penny Stocks

  1. They are risky

    They carry more risk than regular stocks because of their lower prices per share and higher volatility. Because these are highly speculative investments, they are certainly not for everyone.

  2. They offer less liquidity

    There is a much lower volume of shares trading hands everyday. When fewer shares are being sold, any significant purchase or sale may push the stock to higher or lower levels. Less volume also means the investor runs the risk of not being able to sell their shares at their desired price.

  3. They have small market capitalization

    Hence the term micro-cap stocks, their market capitalization is usually in the range of $50-$300 million. This is the result of a low price per share paired with a low number of shares outstanding.

  4. There is less information available

    This makes it tougher to make sound investment decisions. There are less ratios, reports and fundamentals available and much of the information that is available is rarely from credible sources.

  5. They are volatile

    Extreme price swings can happen weekly or even daily as these stocks are very news sensitive. Traders rarely buy these stocks for their strong fundamentals but rather for the potential of an important new product release, for example the next big pharmaceutical drug.

    When critical news is released, share prices will experience excessive swings in relation to the confidence of the news.

  6. They can be manipulated

    Poor liquidity and lack of information make them susceptible to price manipulators who will first purchase a large quantity of the stock, then artificially inflate the share price through false and misleading positive statements. Scammers will use various media platforms such as newsletters, television or online articles to promote “the next big stock”.

  7. They lack history

    If they are newly formed companies, there is no price history and if they are approaching bankruptcy they will generally have a poor track record. Yes, past performance is no indication of future performance, but it is certainly helpful.

  8. The SEC watches them closely

    Sometimes the SEC will even impose trade halts on these stocks if the price spikes too dramatically and suspiciously for further investigation. The stock may continue to rise or fall while halted leaving the investors with no control and open to potential significant losses.

The penny stock market is significantly different from that of regular stocks. Before investing in them, find out more about how the market works.

Due to the nature of penny stocks and how do they work, the make-up of the penny stock market can differ from that of regular stocks. With small market capitalizations and lower prices per share, the way this market moves and the companies associated with this market can be rather distinct.

What is the Penny Stock Market?

The penny stock market is made up of mostly speculative, cheap securities, that exist with volatile conditions. Although some penny stocks trade on major exchanges like the NASDAQ and NYSE, penny stocks are often found trading on pink sheets or over-the counter and have no minimum standards to fulfill.

The companies can be newly formed, have just released an initial public offering (IPO), or are at the later stages of their life cycle and nearing bankruptcy. While there are many former large companies that may find themselves on a penny stock list, it is more common to find pharmaceutical companies claiming to have developed the next big drug ready for international distribution but awaiting FDA approval. Because of this, the penny share market is highly information sensitive and consequently is highly volatile. A lack of fundamental information on penny stock companies creates more speculative purchases and leading to some regarding these trades as gambles

Is the Penny Stock Market for Me?

Learning how to invest in penny stocks is definitely not for everyone. Before being attracted to the success stories of people making massive returns off penny stocks, it is extremely important to understand the risks involved. It is crucial to ensure that penny stocks fit into your overall investment strategy before investing in them.

Like any investment, the risk and return of these investments are correlated. Although there is the potential for big gains, there is often an even greater chance of massive losses. The low liquidity associated with these stocks increases the chances of having difficulty finding a buyer for your shares and this can be extremely painful when the share price is dropping. If you already have a well diversified portfolio, have a little cash that you want to take more risk with and are ok losing, then penny stocks may be right for you. It is important to know what kind of investor you are. Understanding your risk tolerance is a key first step to finding out. Learn more about building your portfolio with Wall Street Survivor’s Building Your Portfolio course pack. Want to know if you are a risk taker? Take this quiz and find out!

5 Things To Know Before Trading Penny Stocks

  1. Do your research

    The more research the better. Although there is minimal information available on the actual companies, the more of it you are actually able to gather, the sounder your investment decision will be. Avoid purchasing a penny stock just because it was recommended to you online. You may become victim of the price manipulators that are so common in this industry.

  2. They move on momentum

    Look for price patterns amongst these stocks. They generally head in certain directions for a period of time before experiencing a reversal.

  3. Set proper expectations

    Don’t purchase penny stocks with the hopes of hitting a home run because chances are you won’t. Take your profits when you can and don’t get too greedy. These stocks can change directions rather quickly.

  4. Don’t bet the house

    Assess the consequential outcome if you loose your entire investment in a short period of time. If it leaves you in a strenuous position, look for a safer investment.

  5. Trading halts may occur

    If the price of a penny stock spikes up to fast, it may be halted by the SEC for further investigation. This can be a problem because the price of the stock may continue to rise or fall while halted leaving the investors with no control and vulnerable to potential significant losses.

Being aware of the differences between is the penny stock market and the regular stock market is great, but it doesn’t stop there. Finding the right stocks to purchase is (obviously) the most difficult part. It is common for investors to not even know where to start when looking for penny stocks. Read on how to find penny stocks and most importantly, how to avoid being the victim of a penny stock scam.

 

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RankStock NewsletterStock
Picks
Average
Return
S&P500
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Percent
Profitable
Max %
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Min %
Return
1.
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2419.9%13.1%6.7%83%107%-28%
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8.Zacks Top 101023.2%26.2%-3%60%120%-24%
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11.Dogs of the Dow1014.5%26.2%-11.7%70%95%-25%
12.IBD Top 50 Leaderboard5013.5%26.2%-12.7%n/an/an/a
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